The first thing that you need to know is that bank panics are inherently deflationary. They were in 1879; they were in 1837 and they were in 1929. Even if there is plenty of money on the national balance sheet, you get deflation when money gets hoarded.
Taking the money out of active circulation has the same effect as shrinking the money supply. This means that the central bank must aggressively add money to the system in times of panic.
It also means that it must aggressively take money out of the system in times of recovery. Under normal monetary policy it takes a long time for new money to work its way from the ‘printing press’ to final consumer purchases. But panics are different, since they deal with the circulation of money that is already out there in the economy, panics can cause very sudden deflation, and recoveries can cause very sudden inflation. The fed needs to be agile in order to deal with this.
- The Pros and Cons of Rate Cuts
- Farrell: Market in a Bottoming Process
- Wall Street in Crisis: Special Report
- Risk and You: What You Need to Know
- Complete Earnings Coverage
The Fed has not been particularly agile. Today’s rate cut was late and small. Really, the cut was not actually a cut at all. Bernanke had already been pumping enough money into the system to lower the rate at least to 1.5%. What changed today is that it was made official. We didn’t get more money today – we got an announcement of what had already been happening. Will it be enough? No.
It does show the markets however, that the Fed has the direction right. That’s a big step which may help markets in the short run. But like so many other Bernanke moves will there be a follow-up on the promising start? Don’t count on it.